Abandoned last year, bond funds are back on top

NEW YORK (AP) -- Bond funds have made money so far this year as many stock markets around the world have faltered.

It's another reminder of how bonds can help stabilize a portfolio and protect investors during inevitable drops in the stock market. Not bad for a group of investments that many were dumping last year: Investors pulled a net $83.4 billion from bond mutual funds in 2013, according to the Investment Company Institute.

"It's not sexy, but fixed-income is still the most effective mitigator of equity risk," says Jim Lauder, portfolio manager of the Wells Fargo Advantage Dow Jones Target Date mutual funds. "If you look at what happens when the world falls apart, other asset classes don't provide the same type of diversification benefits."

To be sure, most strategists say they expect conditions to remain tough for bonds in coming years. Bonds had their first annual drop last year in more than a decade. Interest rates are low, which not only means that they offer small interest payments but they're also under threat to drop in price. That's what happens when interest rates rise, and many strategists expect that to occur. But the early 2014 leaderboard for mutual-fund performance shows the risk of abandoning bonds.

Consider Lauder's target-date mutual funds, which are built for people saving for or living in retirement. His portfolios have a larger percentage of assets in bonds and cash and less in stocks than many rival target-date mutual funds.

The less-risky approach means they may lag behind peers when the market is soaring, like last year. But it also helps provide a steadier ride during rocky periods: The Wells Fargo Advantage Dow Jones Target Date fund for investors planning to retire in 2020 ranks in the top 9 percent of its category for returns this year, for example.

The largest category of bond mutual funds by assets, intermediate-term bond funds, has returned an average of 1.3 percent this year, according to Morningstar. That beats the performance for all kinds of stock mutual funds, including the drops of 4.5 percent for emerging-market stock funds and of 1.9 percent for U.S. large-cap value stock mutual funds.

The difference was starker before this week's rebound for stock prices. In January, the average intermediate-term bond fund rose an average 1.3 percent versus a drop of 6.3 percent for emerging-market stock funds and 3.6 percent for U.S. large-cap value stock funds.

The clearest example of how bonds can offset the risk of stocks may be 2008, when the financial crisis dragged the Standard & Poor's 500 index to a loss of 37 percent after including dividends. Funds focused on intermediate-term government bonds had a positive return of 4.8 percent that year, the result of nervous investors piling into Treasurys in search of safer investments.

Bonds don't have a perfect record of zigging when stocks have zagged, says Jason Brady, portfolio manager at Thornburg Investment Management. Last summer, both stocks and bonds fell when worries flared that the Federal Reserve would soon start slowing its bond-buying stimulus program, for example.

But the shakiness for stocks early this year still sent some investors back to traditional bond mutual funds, at least temporarily. Taxable bond funds attracted a total of $3.49 billion in net investment last month, according to Morningstar.

Among Thornburg's traditional bond funds, Brady says he saw increased dollars flow into the Limited Term Income fund, which has a five-star rating from Morningstar. But Brady expects that to diminish, given the relatively low yields.

He expects the interest to continue for his Thornburg Strategic Income fund and other mutual funds that invest in more esoteric areas of the bond market across the world. Such nontraditional bond funds would be less vulnerable to jumps in Treasury yields, though they also may offer less protection as a diversifier for when stocks are falling.

"People have not been very aware that fixed-income markets are much larger and more diverse than people give them credit for," Brady says.